Bonds: The “Safe” Alternative to Stocks?

Bonds are considered to be a safe alternative to the stock market. While it’s true that they aren’t as volatile as stocks – and high-quality bonds often increase in value during times of stock market volatility – bonds do have risks that all investors need to consider.

“. . .In 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.”
– Warren Buffet, 1984 Letter to Shareholders

One of the biggest risks that bond investors face is low return potential. As I write, the yield on the 10-year Treasury is only 1.50%. Even the yield on the 30-year Treasury is well below the historical inflation rate at a paltry 2.23%. I don’t know about you, but earning a sub-inflation rate of return for the next 10 to 30 years would cause some “problems” in my financial plan!

Bond investors also have to deal with interest rate risk. Since bond prices and interest rates move in opposite directions, an increase in interest rates will result in declining bond prices and losses for bond investors. Since longer-term bonds fluctuate more in response to interest rate changes than shorter-term bonds, investors can reduce their interest rate risk by avoiding long-term bonds in favor of short- or intermediate-term bonds.

Unfortunately, bonds with shorter maturities have lower yields than longer-term bonds. Expanding beyond Treasuries can help increase the yield on a diversified bond portfolio, but only slightly. For example, the 30-day SEC yield for Vanguard Total Bond Market (VBTLX) – an index fund that invests in intermediate-term government, corporate, securitized, and other types of bonds – is currently 1.91%. Although that’s higher than the 1% mentioned by Buffet in the quote above, it’s still abominable!

I’m not saying that bonds don’t deserve a place in a portfolio. What I am saying is that we should all be aware of the tradeoff between risk and return when making investment decisions. Bonds do reduce the volatility risk of a portfolio, but this comes at a price. That price is interest rate risk and lower expected returns. Even retirees should be careful about how much they hold in bonds given today’s low interest rate environment.